August 20, 2007

How Long Is Your Lever?

"Give me a lever long enough and a fulcrum on which to place it and I shall move the world." Archimedes (287 - 212BC)

The word, leverage, has been passed around every corner of the financial universe over the past several months. For better or worse, it has become a "sexy" word -- one that brings that instant gratification of, "Yes, leverage is what I need. And anyone using it must be wise." As investors have recently learned, leverage can work for you or it can work against you. Today, we'll start with the basics of leverage then cite a few of the many uses of the term that has been used for centuries. Hopefully, you will discover just how long your lever is...

General Definition

First, leverage can be generally defined, in the physical sense, as an assisted advantage. As a verb, to leverage means to gain an advantage through the use of a tool. For example, a heavy object is more easily lifted with a lever than it is unassisted. Think of a hinge that assists in opening a heavy door or a pulley that helps lift large objects otherwise unmovable.

Financial Leverage

More recently, leverage has become an automatic term for a business, individual or other entity utilizing borrowed money (aka "other people's money") for financial gain. Businesses have recently used leverage to strategically change their financial structure by purchasing more company stock with low interest rate loans or by expanding their business by purchasing other businesses, in the form of "leveraged buyouts."

Financial leverage is assumed to always be intended as a wise use of resources, such as a tax advantage for the corporation and/or an increase in the return on the shareholder's investment; however, it can have negative outcomes. Companies (and individuals, alike) that are highly leveraged increase the risk of bankruptcy; therefore risk erosion of their share price (for the individual, personal net worth) as well as their borrowing capacity (additional financing ability, bond/credit rating).

Recently, examples of leverage working against the user have shown their ugly results in the form of subprime mortgage resets, hedge fund implosions, credit market contagion, and broad stock market jitters. I've referred to this poor usage of leverage and its messy outcome as part of the cycle of greed.

Good Debt vs. Bad Debt

Many economic theories, most notably that of Modigliani-Miller, suggest that a highly levered firm (financed with debt) can be just as profitable as an unlevered firm (financed with equity) and the "optimal" level of debt or capital structure depends on the firm itself. While the MM Theorum has its merits, it has much less application in the world of personal finance. Individuals should seek prudent debt management to maintain "good debt:"

Debt should be maintained to the degree that it keeps financial risk at a manageable level;

The proper level of debt should serve its purpose to the individual yet ensure future financing flexibility;

And the level of debt will allow the individual to maintain a desirable credit rating.

General words of wisdom: Spend less than you make; too much debt can be just as foolish as too little; a prudent debt-to income ratio level is between 20 and 36; and use debt less on depreciating assets and more on appreciating assets.

For investors

In a financial sense, leverage can take on several meanings. The most common application of financial leverage is applied through the time value of money, which refers to the fact that a dollar in hand today is worth more than a dollar promised at some time in the future. Applying leverage, you must earn interest on your dollar to allow it to "work" for you until you need it later. Ultimately, you must earn interest above the rate of inflation, not only to maintain your dollar's purchasing power but, to increase it.

Time and its companion, compounding interest, are the most powerful applications of financial leverage. All other considerations being equal, the longer your investment time horizon, the longer your lever. For example, consider two investors, both age 18: The first investor immediately begins making an annual $4,000 IRA contribution today and stops contributing in eight years at age 26 -- the second investor waits nine years and starts at age 27, contributing the same amount and earning the same rate of return (8%) until stopping at age 65. The first investor (using time as a lever) ends with $1,004,764 (total contributions, $36,000). Even after more than 40 years of contributions (total, $152,000), the second investor is still behind with $951,765.

Knowing yourself is the key to success while understanding risk is vital here. Check a previous TFP post, "Know Thy Risk," for more specifics. Most investors should stick to the tried, the true, and the boring-yet-prudent practices of dollar-cost averaging, balanced asset allocation, or even a life-cycle fund approach.

Also remember, your lever's length can be shortened by imprudent investment selection or usage, inappropriate asset allocation, and any application of your emotions to investment decisions.

Levering Knowledge

As I stated above, knowing yourself is the key to financial success and has applications in every other aspect of your life as well. Of course, there is more to knowledge than self-acquaintance. Knowledge of your pursuit and its requirements for success is necessary to reach your destination. If you lack the skills to do something yourself, logic says you should lever the knowledge of others. Here are a few examples:

Do you have the time, resources, ability, and the passion to study corporate financial statements? If not, then you should invest in mutual funds and lever the knowledge of a professional money manager (except when index funds are appropriate).

Would you recommend you as a financial advisor? In my personal investment advisory practice, my best clients will agree that my primary role as their advisor is to protect them from themselves. Generally, if you've acquired at least six figures in investable assets and your financial picture is not so simple any more, a financial planner with experience and expertise in your area (and without bias to a large firm or any proprietary investments) is wise.

For the individual investor who wishes to manage their own investments and possesses the aptitude and passion required for success, the active-management style of my "Socratic Model" may be a logical place to begin. Just remember a few things to lever knowledge of others for yourself: Education never ends; read more books than "news;" there is no such thing as original thought; understanding behavioral finance is necessary; and doubting yourself and others (critical reasoning) should remain central to your investment philosophy.

Lever or Be Levered

In the end, whether you are an individual investor, a trader, or someone simply finding their way through the maze of personal finance, the length of your lever essentially depends on your ability to minimize risk and maximize return as well as knowing what that means. Assuming excessively high or excessively low levels of the many types of risk will potentially shorten your lever -- the highest returns typically require higher amounts of risk and the lowest levels of risk will likely result in inadequate returns. Therefore, it is prudent to seek moderation; thereby avoiding foolish levels of risk, achieving an "acceptable" return, and freeing time to pursue your true passions -- all at the same time.

Going back to the beginning of my post, you'll do do well to remember the broad meaning of leverage -- a means to gain advantage through the use of a tool. You must use the "tools" of leverage for financial gain only with the ultimate objective of using money as a means for the pursuits of your life -- not for pursuing money as an end to a means. Otherwise, you may find yourself to be "the tool" being levered...

Comments

"Give me a lever long enough and a fulcrum on which to place it and I shall move the world." This philosophical thought is quit interesting and useful to understand basic financial mechanism.I really loved this quote.

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The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.